This time of year, everyone is looking to find ways to avoid large tax burdens. Contributions to your child or grandchild for college savings may be a great way to plan for the future and get some tax relief right away. As a college savings tool, 529 plans are the most popular choice to maximize tax-free growth of your investment, as long as it is used entirely for qualified secondary educational expenses. An individual can contribute up to $70,000 and a couple up to $140,000 to one beneficiary in a single year, as long as they count it towards their annual gift tax exclusion over a five year period. Many of the 529 plans allow for maximum account values of over $300,000. The 529 contributions are considered an asset of the custodian, allowing for flexible financial aid qualification for the student and transfers of the funds between accounts for other beneficiaries. Each state has its own plan and investment module and many offer tax benefits for contributions by residents. If your state does not offer tax incentives, then you are free to invest in any of the top-performing 529’s in other states, as most plans do not have residency requirements to participate. DWM can help find the best direct-sold plans with low operating expenses and good allocation menus. South Carolina’s direct sold plan ranks in the top 10 and Illinois in the top 15 for the last 5 years and both offer tax incentives for residents.
Before the 529’s were created, the investment choice for many was the Uniform Gift to Minor Acts (UGMA) or Uniform Transfer to Minors Act (UTMA) custodial accounts. These plans offer the advantage of allowing for non-qualified educational expenses without penalty. For example, if you want to use the funds to buy a car for your teenager. The UGMA/UTMA accounts also offer a full range of investment options with the ability to choose allocations and make changes as you would with any other investment account. There is also no limit on the maximum contribution amount. UGMA/UTMA accounts are taxed on their growth and mandated by the rules of the “kiddie tax”. This tax provision allows for the first $1,000 of unearned income of the minor to be tax-exempt and then the second $1,000 is taxed at the young account holder’s lower tax rate. Any gains from investment growth, dividends or interest above that $2,000 unearned income limit will be taxed at their parent’s higher tax rate. This tax provision affects all account holders under 19 or dependent full-time students between ages 19-23.
So what happens if you are the custodian for a UGMA/UTMA for a minor child or grandchild and you want to move it to a 529? 529’s can only accept cash deposits so the account will have to be liquidated and the custodianship terminated. The irrevocable provisions of the beneficiary arrangement in Uniform Minor acounts, however, must still be maintained, even in the 529. The 529 will ask for the source of the funds, and, if coming from a UGMA/UTMA, some 529 plans will register it as a Custodian 529. This simply means that the beneficiary rules designate the account holder be given control of the asset at age 18. The same Uniform Minor laws apply regardless of what kind of account these funds transfer to because the original asset was in an irrevocable account. Funds cannot be transferred or used by siblings or other family members without a penalty.
Is it prudent to move the funds into a tax-exempt 529? The biggest consideration are the taxes created by the liquidation of the UGMA/UTMA account and/or the annual taxes owed by the minor during its operation. After evaluating the potential gains to be made during the life of the account, you must consider what the tax on those gains will be. You can choose to liquidate the account in pieces over time or all at once, depending on the tax burden created. The tax must be paid at some point, so perhaps sooner rather than later will prevent it from increasing. Another choice is to leave the assets where they are and put any additional contributions in a new 529 for the beneficiary. This will avoid causing a taxable event while creating a beneficial 529 account. There may be a tax benefit to transferring the funds into a state-sponsored 529 plan because of tax breaks offered by some states, like South Carolina and Illinois. The tax owed on the gains may be offset by the tax incentives offered. You will have to weigh the implications of the long-term tax-saving benefit of transferring into a 529 against the tax burden created by liquidating the account.
While it’s true that the 529 is an excellent college-saving tool, there can be advantages to using the Uniform Minor accounts as well. And a conversion of a UGMA/UTMA account to a 529 can be a complex decision. At Detterbeck Wealth Management, we can help you evaluate your situation to determine the best option.